Transcript 2008+ GLOBAL CRISIS

2008+ GLOBAL CRISIS
Hasan Ersel
HSE
May 25, 2011
MARKET SYSTEM IS NOT MANNA FROM
HEAVEN
• Market system is a human product. If it is well designed
it works well, otherwise it doesn’t...
• Markets don’t operate in a vacuum. Their performance
depends on the environment in which they are operating.
• Environment consists of regulations, ethics, traditions,
institutions, information dissemination, incentives etc.
• Bad incentives and bad information generate bad
behavior [Jean Tirole]
PRE-CRISIS DEVELOPMENTS
• Low interest rates and housing boom (Notably in the
USA and UK) [Pure Economic Policy Decision]
• A dangerously rising debt to equity ratios in various
financial institutions (Regulatory forebearence: refraining
from doing something that one has a legal right to do. A
delay in enforcing a legal right.)
• The rise in homeownership in the USA
• The US government agencies’ policies that discriminate
in favor of housing for the poor
• Financial Innovations (MBS, CDO, CDS)
PRE CRISIS MONETARY POLICY IN THE
USA: THE GREENSPAN PUT
• The term "Put" refers to a “put option”, in which the buyer of
the put acquires the right to sell an asset at a particular
price to a counterparty; as such it is exercised if prices
decline beneath this level.
• During this period (1987 to 2000s), when a crisis arose, the
Fed would lower the Fed Funds rate, often resulting in a
negative real yield. In essence, the Fed pumped liquidity
back into the market to avert further deterioration.
• The Fed did so after the 1987 stock market crash, the Gulf
War, the Mexican, the Asian, the Long Term Capital
Management crises, Y2K, the burst of the international
bubble, the 9/11 and repeatedly from the early stages of the
Global Financial Crisis to the present.
FINANCIAL INNOVATIONS
• MBS: Mortgage Backed Securities is an asset-backed
security that represents a claim on the cash flows from
mortgage loans through a process known as
securitization.
• CDO: Collateralized Debt Obligation is a structured
asset-backed security (ABS) whose value and payments
are derived from a portfolio of fixed income underlying
assets)
• CDS: Credit Default Swap is a form of insurance that
protects a lender if a borrower of capital defaults on a
loan. When a lender purchases a CDS from an
insurance company, the liability of the loan becomes a
credit that may be swapped for cash upon the loan
defaulting.)
WERE THERE WARNINGS?
Yes... Many! For example:
•
•
•
•
Raghuram Rajan (University of Chicago)
Nouriel Roubini (New York University)
Robert Shiller (Yale University)
Joseph E. Stiglitz (Columbia University)
• What happened? They were omitted...
THE CHRONOLOGY OF THE CRISIS-2007
(1)
• US home sales fell,
• US home prices year-on-year declined for the first time
since 1991,
• Subprime Mortgage Business Collapses,
• Foreclosures double versus 2006
Foreclosure is the legal process by which a mortgagee,
usually a lender, obtains a termination of a mortgagor’s
equitable right of redemption (Redemption value is the
price at which the issuing company may choose to
repurchase a security before its maturity date)
• Interest rate increases.
THE CHRONOLOGY OF THE CRISIS-2007
(2)
• April 2: New Century Financial, largest US subprime
lender, files for bankruptcy (subprime lending means
making loans to people who may have difficulty
maintaining the repayment schedule.)
• June 7: Bear Sterns announces halting redemptions for
two of its funds
• August 9: European bank BNP Paribas follows
• August 9: ECB injects € 95,5 billion overnight!
• September 14: Bank of England injects liquidity to
support Northern Rock
• November 20: Freddie Mac announces third quarter loss
• November 1: FED injects US$ 41 billion
THE CHRONOLOGY OF THE CRISIS-2008
(1)
• January 15: Citigroup announced that it is to rise US$
14,5 billion in new capital
• February 11: American International Group (AIG)
announces that its auditors have found material
weakness in its internal controls over the valuation of a
portfolio of credit default swaps.
• February 17: UK government announced temporary
nationalization of Northern Rock.
• March 16: J.P. Morgan Chase agreed to purchase Bear
Stearns. FED provided US$ 30 billion funding.
• September 7: Fannie Mae and Freddie Mac taken into
conservatorship.
THE CHRONOLOGY OF THE CRISIS-2008
(2)
• September 15: Lehman Brothers files for bankruptcy
(The crisis becomes global)
• September 16: US government provides emergency loan
to AIG of US$ 85 billion and takes 79,9% stake and the
right to veto on dividend payments.
• September 18: Financial Services Authority of the UK
announced temporary prohibition of short-selling of
financial shares.
• September 19: SEC followed...
• September 20: US Treasury announced its plan to
purchase up to US$ 700 billion of troubled assets
[Troubled Asset Relief Program (TARP)]
THE CHRONOLOGY OF THE CRISIS-2008
(3)
• September 29: Iceland Government buys stake in Glitnir
Bank as part of rescue
• September 29: Belgian, Dutch and Luxemburg
governments to invest € 11,2 billion in Fortis Bank.
• October 3: Dutch government acquired Fortis Bank’s
Netherlands business.
• October 6-10: Worst week for the stock market for 75
years. DJ-Industrial Average losses 22,1%
• October 6: German government announced package to
save Hypo Real Estate
• October 6: BNP Paribas announce takeover of Fortis’
operations in Belgium and Luxemburg as well as the
international banking division of Fortis.
THE CHRONOLOGY OF THE CRISIS-2008
(4)
• October 6: FED announced that it will provide US$ 900
billion in short term loans to banks.
• October 7: FED made emergency move to lend US$ 1,3
trillion to companies outside the financial sector.
• October 11: DJ Industrial Average recorded its highest
volatility day ever in its 112 year history
• October 14: US government announced Capital
Purchase Plan (CPP) up to US$ 250 billion to take
stakes in US banks.
• October 19: Dutch government injects € 10 billion into
ING
THE CHRONOLOGY OF THE CRISIS-2008
(5)
• October 21: FED announced that it will spend US$ 540
billion to purchase short term debt from money market
mutual funds with the intention of unfreezing credit
markets
• November 12: US Treasury Secretary Hank Paulson
abandons plan to buy toxic asset under US$ 700 billion
TARP. The remaining US$ 410 billion will be spent in
capitalizing financial companies.
• November 23: Citigroup to issue preferred shares to the
US Treasury and FDIC in exchange for protection
against its unusually large losses.
• November 24: UK government announces temporary cut
in VAT from 17,5 % to 15%.
THE CHRONOLOGY OF THE CRISIS-2008
(6)
• November 25: FED pledges US$ 800 billion more to
help the financial system (US$ 600 billion will be used
to buy mortgage bonds issued or guaranteed by Fannie
Mae, Freddie Mac and Federal Home Loan Banks) The
US Treasury will invest an additional US$ 20 billion in
Citigroup from TARP, taking its input to US$ 45 billion.
• November 26: FED approved the notice by Bank of
America to acquire Merrill Lynch.
• December 4: Bank of England reduces bank rate to 2%.
• December 16: FED establishes target range for the
federal funds rate of 0% to 0,25%.
THE CHRONOLOGY OF THE CRISIS-2009
(1)
• January 19: UK government announced the Asset
Protection Scheme to protect financial institutions
against exposure to exceptional future credit losses on
certain portfolios of assets.
• January 19: FSA issues statement indicating that banks
are expected to maintain a minimum core Tier 1 capital
ratio of 4% and expressing preference to incorporate
countercyclical measures(!)
• March 5: Bank of England reduced bank rate to 0,5%
and announced GB£ 75 billion asset purchase program
• March 18: FED Announced an expansion of over US$ 1
trillion in its planned asset purchases this year.
THE CHRONOLOGY OF THE CRISIS-2009
(2)
• April 9: German government begins the process
to take over Hypo Real Estate.
• May 7: FED releases the results of the stress
test of 19 largest US bank holding companies. It
finds that losses at the firms in 2009 and 2010
could be US$ 600 billion and ten firms would
need to add, US$ 185 billion to their capital to
maintain adequate buffers if the economy were
to record the more adverse scenario considered.
• May 7: ECB Lowers its interest rate to 1%
• And it still continues...
AN EXTERNAL FINANCIAL SHOCK
• An external financial shock not only affects the
financial sector of a country but can easily spread
other sectors. (Linkage)
• Therefore an external financial shock affects both
domestic financial sector and the real sector. The
effect on real sector can be both direct (external
financing) and indirect (through domestic financial
system)
• The total effect on the real side of the economy,
therefore, may be much stronger and more
widespread than is observed from financial sector
accounts.
FINANCIAL SECTOR RESPONSE TO
EXTERNAL SHOCKS
• It is well known that, financial sector has the
tendency and capability to amplify the business
cycles.
• This problem was first posed by Irvin Fisher in 1933.
Later, Bernanke & Gertler (1989) discussed the
problem and offered an explanation known as
“financial accelerator theory”.
• More generally “pro-cyclicality” of the financial
sector became a major concern and research area,
especially after a series of crises in 1990s that hit
both developed and developing countries.
FINANCIAL ACCELERATOR AND THE
CREDIT CHANNEL
• A weak banking system grappling with nonperforming
loans and insufficient capital or firms whose
creditworthiness has eroded because of high leverage or
declining asset values are examples of financial
conditions that could undermine growth.
• Changes in financial and credit conditions are important
in the propagation of the business cycle, a mechanism
that has been dubbed the "financial accelerator."
• Changes in financial conditions may amplify the effects
of monetary policy on the economy, the so-called credit
channel of monetary-policy transmission.
EXTERNAL FINANCE PREMIUM
• The effects of a real shock (such as a shock to
productivity) on financial conditions could lead to
persistent fluctuations in the economy, even if the
initiating shock had little or no intrinsic persistence
(Bernanke and Gertler, 1989)
• Moreover, the theory predicts that the external finance
premium that a borrower must pay should depend
inversely on the strength of the borrower's financial
position, measured in terms of factors such as net worth,
liquidity, and current and future expected cash flows.
HOW FINANCIAL ACCELERTAOR
WORKS?
• The inverse relationship of the external finance premium
and the financial condition of borrowers creates a
channel through which otherwise short-lived economic
shocks may have long-lasting effects.
• An improvement in the cash flows and balance sheet
positions of firms leads in turn to lower external finance
premiums in subsequent periods, which extends the
expansion as firms are induced to continue investing
even after the initial productivity shock has dissipated.
• This "financial accelerator" effect applies in principle to
any shock that affects borrower balance sheets or cash
flows.
INFORMATIONAL CAPITAL OF BANKS
• A central function of banks is to screen and monitor
borrowers, thereby overcoming information and incentive
problems.
• By developing expertise in gathering relevant
information, as well as by maintaining ongoing
relationships with customers, banks and similar
intermediaries develop "informational capital."
• During banking panics banks facing the risk of runs by
depositors, were forced to constrain lending to keep their
balance sheets as liquid as possible. Banks were thus
prevented from making use of their informational capital
in normal lending activities.
• The resulting reduction in the availability of bank credit
inhibited consumer spending and capital investment,
worsening the contraction.
HOW DOES A FINANCIAL SHOCK
AFFECTS A COUNTRY (1)
Finance Channel
i) External borrowing of the real sector (and if
applicable, government’s )
ii) Bank borrowing from international financial
system
HOW DOES A FINANCIAL SHOCK
AFFECTS A COUNTRY (2)
Trade Channel
i) Decline in world demand for country’s exports.
This may reflect as a decline in export prices
and/or physical volume.
ii) Similar effects also observed for imports
HOW DOES A FINANCIAL SHOCK
AFFECTS A COUNTRY (3)
Expectations Channel
• Change in global environment may affect the
behavior of domestic agents, notably banks. That
may lead banks to curb credits, consumers to
reduce their demands and producers to revise their
production plans downward.
2008 CRISIS: THREE SHOCK WAVES
1) The initial shock: The direct effects of the
recession in the USA and the EU (the center) on
other countries.
2) The secondary shock: The indirect effect through
the economic relations of one country with other
countries that also affected by the crisis at the
center. (Dubai crisis)
3) The tertiary shock: The direct and indirect effects
of the measures taken by other countries on the
country in question.
HOW DID 2008+ CRISIS AFFECTED
RUSSIA?
MAY IT BE AN EXAM
QUESTION?